S&P downgrades to junk but Moody’s grants 3-month reprieve

27 November 2017

Nazmeera Moola, co-Head of Fixed Income, Investec Asset Management

The three major global credit rating agencies updated their opinion on South Africa’s credit worthiness last week. Fitch left their ratings unchanged, with both the hard currency and local currency ratings at one notch below investment grade with a stable outlook.

S&P downgraded both ratings by one notch: foreign currency to BB and local currency to BB+. Both now have a stable outlook. Moody's placed South Africa’s Baa3 foreign and local-currency ratings on review for a downgrade, with a decision expected to follow by the end of March 2018.

Credit Ratings: Foreign vs Local Currency Debt

S&P

Fitch

Moody's

Foreign

Local

Foreign

Local

Foreign

Local

Sep-15

BBB-(stable)

BBB (stable)

Sep-15

BBB (neg)

BBB (neg)

Dec-15

Baa2 (stable)

Baa2 (stable)

Dec-15

BBB-(neg)

BBB(neg)

Dec-15

BBB-(stable)

BBB-(stable)

Jan-16

Baa2 (neg)

Baa2 (neg)

Apr-17

BB+ (neg)

BBB - (neg)

Nov-16

BBB- (neg)

BBB-(neg)

June-17

Baa3 (neg)

Baa3 (neg)

Nov-17

BB (stable)

BB+ (stable)

Apr-17

BB+ (stable)

BB+ (stable)

Nov-17

Baa3(neg watch)

Baa3(neg watch)

The base case for Moody’s is that they will conclude the review in the month following the release of the 2018 Budget, which is currently scheduled for 21st February 2018. They noted that this gives them time “to assess the policy implications of political developments during the review period and the likelihood of pressures on South Africa's key policymaking institutions persisting.” While S&P believes that South Africa’s poor policy making in recent years has done so much damage to the country’s competitiveness that this cannot be reversed in the next six months, Moody’s is providing South Africa with a 3-month window to provide evidence of policy responses that will result in higher growth and ultimately stabilise the debt-to-GDP ratio.

This highlights the importance of the outcome of the ANC electoral conference scheduled for 16th-20th December and the subsequent response from the ANC’s newly elected president in January 2018. Only by a significant show of leadership in key areas will a downgrade from Moody’s be averted.

Flow implications of the ratings changes

A downgrade of the local currency rating by S&P, but not by Moody's, implies that South Africa's sovereign bonds will fall out of the Barclays Global Aggregate Bond Index (BGAI), but not out of the Citi World Government Bond Index (WGBI). This will likely result in forced sales of US$1bn-1.5bn in the next two weeks. However, the much bigger risk is WGBI exclusion – estimates of forced selling from such a move vary between US$6bn-US$10bn.

In a favourable global environment, net outflows over the next six months could be limited. However, the downgrades coupled with a potential ejection from the WGBI leave South Africa vulnerable to any potential change in the global environment. Emerging Market debt funds have received inflows of US$65bn since the start of 2017. Foreign investors own 40% of all South African government bonds outstanding. South Africa is dependent on the kindness of strangers to finance its deficit. As South Africa falls out of BGAI and potentially the WGBI, foreign high yield investors may displace investment grade investors. However, foreign investment grade investors are ultimately far more reliable than foreign high yield investors.

Finally, credit ratings are the report card – not the cause of the problem. The deterioration in the credit environment in recent years reflected by these rating changes has already resulted in South Africa paying ZAR5bn more for the debt it has issued in this year alone. This will compound sharply in the coming years, unless the trend is reversed.

S&P downgrades on weak growth outlook

In making their decision, S&P assessed the risks of weak growth and the deteriorating fiscal position and decided to act. The positive points S&P notes are:

Monetary flexibility and the freely floating exchange rate

Deep capital markets

90% of South Africa’s government debt is denominated in rand

An improved external position, as the current account deficit has narrowed in 2017

A profitable and well capitalised financial sector

Their concerns are:

Weaker growth than they had previously projected, with little likelihood of a strong pick-up in 2018. Moreover they are concerned that consolidation moves in the 2018 budget will further exacerbate the weak growth outlook.

High income inequality, which is likely to put pressure on government spending. The pressure for free higher education is a case in point.

No structural reforms. Little evidence of moves to decrease income inequality, such as ambitious structural reforms to education and labour markets, or a recomposition of public spending away from public sector wage increases and toward social and education programmes.

High contingent liabilities. Weak balance sheets of state-owned companies, notably Eskom, although SAA and the SA Post Office are also mentioned. S&P notes that “Over the next six months, we anticipate that appropriations may be required to shore up Eskom's very weak financial position.”

Moody's concerns: Budgetary shortfalls and governance

The two primary concerns that Moody’s highlighted were:

Weaker growth than they had previously forecast. This has resulted in a large undershoot in revenue collection and the subsequent increase in the debt burden. Moody’s now expects Debt-to-GDP to reach 60% by 2020/21. This is sharply higher from their previous expectation that the debt ratio would still be around 55% of GDP at that time.

High contingent liabilities. The threat that high contingent liabilities present due to guarantees provided to State Owned Enterprises. Chief amongst these is Eskom, where there has been no progress in permanently removing previous management or the appointment of a new board.

Institutional erosion. Political decision-making has led to the erosion of institutions, most notably at the National Treasury, which prior to the March 2017 cabinet reshuffle was such a success of the post-1994 ANC government.

However, the agency also noted that South Africa's credit profile retains a number of features that support a Baa3 [investment grade] rating. These include:

A large, well-diversified economy

Deep domestic financial markets

Well capitalised banking sector

Well-developed macroeconomic framework

Current debt levels are consistent with Baa3 peers

Flexible exchange rate

Low foreign currency debt

Core institutions remain strong, although they are concerned about the “recent encroachments”

Well-functioning civil society

Adherence to the constitution

Looking forward to the resolution of the negative watch, the agency would opt to downgrade should they conclude that South Africa’s economic, institutional and fiscal strength continues to weaken. The factors they will be assessing are:

Measures to address the funding gap. Given the magnitude of the revenue shortfall, strong and credible measures are required

Structural reforms that ease domestic bottlenecks to growth

SoE governance. The progress on SoE governance, particularly at Eskom

Institutional credibility. “Any developments which cast further doubt over the independence and credibility of core institutions including the National Treasury and the Reserve Bank would be strongly credit negative.”

The agency concluded its three-page note by stating that they would affirm the Baa3 rating if they concluded that “developments in the political economy offer the prospect of a more stable, growth-friendly institutional backdrop.”

SA Rates positioning

The market is deadlocked between what appear to be decent valuations given the low inflation outlook versus considerable political and fiscal uncertainty. Our positioning has generally been conservative and will remain so until we feel confident the deadlock will be broken.

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